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Reassessing the Staying Power of Short-Term Rentals

By Joe Bousquin

COVID-19 put STRs on the ropes, but some institutional apartment companies remain optimistic.

Going into the spring leasing season of 2020, short-term apartment rentals were just beginning to hit their stride.

In contrast to their onetime aversion to home-sharing platforms such as Airbnb and VRBO, institutional apartment operators had enthusiastically begun partnering with short-term rental (STR) platforms like Sonder and Stay Alfred (which is not out of business, according to news reports) to lease apartment homes on a nightly basis at rates that were 30 to 50 percent higher than what they would see from a traditional, 12-month lease.

That enticing premium led institutional operators to cordon off more than 23,000 apartments nationally with STR firms heading into the 2020 spring and summer travel season, according to Chicago-based global real estate advisory Cushman & Wakefield, up dramatically from some 5,300 in 2019.

In contrast to the consumer-oriented Airbnb model, STRs in the institutional apartment sector developed a business-to-business framework, signing long-term master leases with institutional apartment owners to lock in occupancy for large blocks of apartments at market rates, and then renting the apartments out at a premium price for stays as short as one night. Apartment owners benefited from the higher occupancy in their buildings that were holding  those master leases.

“There was a huge swell of institutional acceptance and excitement about short-term rentals,” says Susan Tjarksen, Managing Director at Cushman & Wakefield, who covers the short-term rental market for the firm.

 But then COVID-19 turned out the lights on the whole market, all at once. “When the music stopped with no notice due to COVID-19, that meant bookings dried up overnight,” Tjarksen says. “That meant any source of income dried up overnight, too.”

Scrambling to Fill Apartments

Suddenly, instead of boosting occupancy in one fell swoop through master leases with STR firms, institutional apartment operators found themselves renegotiating leases and extending rent forbearance terms to their STR partners, similar to the deals they were working out with traditional, long-term apartment residents who couldn’t make rent during the pandemic.

“There was blood in the water,” says John Carney, Principal at the Cleveland-based Landmark Cos., an owner and operator of some 700 apartments, which had partnered with STR firms Stay Alfred and Front Desk, as well as a local operator who leveraged Airbnb listings to lease  single Landmark apartments. “We had buildings that were running occupancies in the mid-90 percent range that all of a sudden, overnight, fell into the low 80s.”

By April, STR firms that had been ascendant darlings in the institutional apartment sector, such as Sonder and Lyric, were taking drastic measures just to stay afloat, announcing deep layoffs to staff and frantically trying to lengthen their average stays to lock in occupancy for longer than a day or two. Others transitioned to offering short-term rental management to apartment owners rather than sign long-term master leases with them. And the pandemic completely overtook Spokane, Wash.-based Stay Alfred, one of the most recognizable names in STR, which shuttered permanently in May, according to news reports.

Working Through COVID-19

The shakeout illustrates the risk to apartment owners who issued master leases to take down large blocks of apartments in one fell swoop, and raises questions about the long-term viability of the short-term rental model for institutional apartment firms. On the other hand, it shows how a thoughtful approach to STRs can benefit owners when things go sideways. More immediate, though, is the issue of what institutional owners do with the empty apartments that have been left behind, many of them still furnished.

Some owners have pivoted to working with STRs as fee managers for a significantly pared-down inventory of short-term apartments, rather than risking the long-term exposure of extending their master leases with them. Other owners have turned to more traditional corporate housing models to try to lease their suddenly vacant short-term apartments for longer stretches — three to six months. But all owners are trying to build occupancies that last longer than just a few days.

That’s what Landmark and Carney are doing at The Block, a 163-apartment tower in downtown Indianapolis where Stay Alfred left 20 furnished apartments vacant on April 1. Landmark was able to hire an operations manager with corporate housing experience, and has now secured longer-term leases on six of those apartments. The company hopes to work through the rest of them this summer.

“Obviously, no one's traveling right now, but corporations are still sending some people out for things like training,” Carney says. “So our decision was to do our best to get 12-month furnished leases, but if we can’t get 12 months, let’s aim for six. If we can’t get six, let’s aim for three, because you get what you pitch for. The longer the better.”

The lesson he’s taken from the experience is that while risk is an inherent part of the apartment business, isolating that risk from the core operations at a company is key to success.

“A company our size has to be flexible and take calculated risks by trying new things,” says Carney. “We aren’t shutting the door on the short-term opportunity; we’re just going to be cautious as to the percentage of units we dedicate to that business.” The firm is now limiting short-term rentals to 7 to 10 percent of a property’s apartments.

Taking a Cautious Approach

At Chicago-based Waterton, an operator of around 22,000 apartments at 59 properties, which had started testing short-term rentals at select properties just before COVID-19 struck, that limit is even lower. “It’s less than 5 percent at just some of our communities,” says Waterton Executive Vice President Lela Cirjakovic. “For us, it was augmenting our existing business. As an operator, if I can get another half percent in occupancy in my community, that is a win for us and it’s a win for our investors.”

As Waterton began investigating short-term rental potential at its properties, the company was also very conscious of the business model it was entering  into with STR firms. For instance, while it had some master leases in place for STRs, it also contracted with STR firms to manage a set amount of its apartments on a fee basis. And when Waterton did enter into such leases, it made sure that their expirations were staggered. So while the company did take back some apartments from STR operators whose leases were set to expire anyway during the pandemic, it didn’t have to scramble to fill a lot of apartments all at once.

“So if we have 10 apartments with a short-term provider, we stagger those lease expirations to minimize the potential impact,” Cirjakovic says. “We received some apartments back, but we didn’t have any premature notices or buyouts or have our partners turn in keys and say, sorry, we can’t pay. We've not seen any of that at any of our communities.”

Other operators are taking similarly cautious approaches. “We’re continuing to work with short-term rental providers, but given the impact of COVID-19, we will carefully evaluate this offering as part of our long-term business plan moving forward,” says Chad Cooley, Managing Director, Strategic Business Solutions, at Greenbelt, Md.-based Bozzuto Management Company, which operates 71,000 apartments.

Underwriting Risk Today, and Tomorrow

For Ari Rastegar, founder and CEO of Austin, Texas-based Rastegar Property Co, the reckoning of short-term rentals in the institutional apartment space underscores the fundamental difference between the two core business models that long-term and short-term rentals represent. One is about providing a primary residence; the other adheres more closely to a hotel-like structure.

“Whatever you want to call it, short-term rental or flexible leasing, it’s an offshoot of hospitality,” Rastegar says. “And hospitality has been hammered, arguably more than any other asset class, by COVID. It’s going to be a long road to recovery.”

At the same time, Rastegar has faith in Sonder — with whom he’s partnered and which, with 5,000 apartments in its portfolio, is arguably the largest STR firm — to make it through the crisis. “Sonder is the only group in town that I would feel comfortable talking with,” he adds. “They have the balance sheet. They have scale. They have expertise. They have a global footprint. Everybody else is so small that I think the risk is way too high.”

Rastegar and Sonder made news in 2019 when the companies announced a 10-year master lease for 1899 McKinney — a planned 26-floor, 270-apartment high rise in Dallas’ Uptown area. Rastegar says the project is now completely entitled, and should break ground before the end of the year.

As for his lease with Sonder, Rastegar says he’s spoken with the firm, and the deal is still on track. “Keep in mind, in a new development scenario like this, you’re underwriting risk three years from now, as opposed to today, in the middle of COVID,” he says.

Institutional Confidence Amid COVID-19

Indeed, Sonder, which has been touted as the best capitalized company in STR, received somewhat of a lifeline, as well as a huge vote of institutional confidence, when it closed a $170 million Series E investment round led by Fidelity on June 24, even as COVID cases continued to rise in the United States. That infusion came after the firm laid off or furloughed more than 400 employees — a third of its staff — at the end of March. At that time, it also changed its focus from acquiring more apartments in its portfolio to leasing the ones it already had for longer stays, locking in occupancy for more than just a day or two.

“We essentially launched a start-up within a start-up, entirely dedicated to longer-term stays,” says Sonder Director of Communications Mason Harrison says, adding that the firm’s occupancy dipped into the 40 percent range before rebounding to 75 percent by late June. “The folks on our real estate team shifted from what they normally do, which is look for supply growth to expand our footprint, to a business-to-business sales mode. We’ve been working with hospitals, schools and other organizations to pivot our portfolio to provide longer-term housing to folks who needed it.”

From Tjarksen’s perspective, that’s the exact area the STR firms that have been able to weather COVID-19 thus far have focused on. “The business models have evolved to try and extend the average length of stay,” she says. “A lot of STR firms who have survived have housed the essential workers, nurses, firemen, policemen, ambulance drivers, people who are every day out in the COVID environment and do not want to take that home.”

Short-Term Management vs. Master Leases

Other STR firms, such as San Francisco-based Kasa, have pivoted away from signing master leases to providing short-term rental management services to institutional operators, while taking a percentage of bookings. So far, that strategy has worked for Kasa, which reports that its portfolio has expanded by 17 percent during the pandemic to 1,000 apartments, including three AMLI Residential properties in Denver and Austin that it took over from The Guild in June.

Roman Pedan, Kasa’s 31-year-old founder and CEO, truly got a baptism by fire guiding his firm through the COVID-19 crisis, when occupancy dipped to 35 percent before recovering to 73 percent by the end of June. He says the fallout of short-term rentals among institutional apartment owners highlights the hidden risk embedded in master leases.

“The real downside to master leases is that they provide a mirage of safety to owners,” says Pedan, who adds that the firm had already started transitioning away from a master lease model at the beginning of 2020 to focus on managing short-term rentals for owners instead. “From an STR company risk-profile perspective, the master lease functions as debt. When times are good, debt amplifies your results. But when times are bad, it amplifies the problems.”

STRs: The Next Phase

Pedan says the upside is that COVID has accelerated the maturation of the STR model in the institutional apartment sector. “To me, the momentum that has been built by operators getting some of their core questions answered about short-term rentals and how they work is a positive,” he says. “That’s what the master lease phase of short-term rentals did. Now, it’s time to transition to implement STRs in a way that’s sustainable.”

Indeed, along with Fidelity’s investment in Sonder, there have been other indications that STRs have staying power at the institutional level. Travel destination booking platform RedAwning recently saw a surge of bookings after restructuring during the pandemic, while apartment hotel platform Domio was the beneficiary of a fawning article in Forbes that highlighted its 85 percent occupanc in June at its Miami property. All of that points to STRs, in some form, still being present in the institutional apartment business going forward.

“Short-term rentals will continue to be part of the multifamily space,” says Tjarksen. “Whether STRs remain independently owned or get absorbed by national property management players is anybody’s guess. But I do think that as a part of the multifamily asset class, short-term rentals will be back in a meaningful way.”